- Reports Q2 2019 results on Wednesday, July 17, after market close
- Revenue Expectation: $4.93 billion
- EPS Expectation: $0.56
As its earnings date approaches, Netflix (NASDAQ:NFLX) continues to enjoy investor confidence, with the stock sitting less than 10% off its 52-week high. But that perch may be precarious.
Netflix is debt-ridden, highly leveraged and is spending money at an unprecedented rate. That, plus the heightened competition expected in the next year could cause this whole house of cards to come crashing down.
Here’s what we’ll be looking for in the earnings report.
All Growth Is Not Equal
Netflix is undeniably a growth story success. The company manages to continuously grow its subscriber base and revenue on a yearly basis. Last quarter, Netflix’s $4.52 billion in global revenue represented a 22% rise over last year’s Q1 global revenue numbers. The number of Netflix’s subscribers is also on the rise. Netflix grew its global subscribers count by 25.2%, to 148.8 million.
U.S revenue, at $2.07 billion last quarter, grew at a pace of 14%, while international revenue, at about $2.36 billion, grew 32.8%. This may not seem important until you see the differences in profit margins: 34.4% for the U.S., but only 11.6% for the international segment. Not all growth is equal and Netflix is growing more where users bring in less money.
Netflix already has wide penetration in the U.S., but we see aggressive growth still priced in at the moment, without necessarily taking into account that Netflix’s growth will be less profitable than it is at the moment.
Debt and Spending Still Loom Large
Netflix’s business model has always involved massive debt and it hasn’t changed its ways in the past year. Netflix’s total contractual obligations (content obligations, debt, and other obligations) has risen from $28.4 billion in Q1 last year to $36.1 billion in Q1 2019, an astonishing $7.7 billion, or 27%. With earnings before interest, taxes, depreciation and amortization (EBITDA) of $1.7 billion, Netflix has 21x more future obligations than current EBITDA.
This isn’t currently a problem since Netflix is expected to grow its EBITDA by the time it needs to pay these obligations, but these obligations will become dangerous and the stock will become very volatile should any hiccup occur along the way.
Netflix is expected to spend $15 billion on content this year and the spending trend is still on the rise. Netflix has been continuously cash flow negative, including a negative $380 million last quarter. Considering the expected spending over the next few years, it is unlikely that Netflix will manage to turn cash flow positive until at least 2022. The only way for Netflix to turn achieve this is to rein in spending and to further increase its subscriber fee. But can it afford to do so? We’ll be looking for management comments on their plans to control its leverage.
Fighting off The Avengers (and Others)
Competition is pressuring Netflix on two fronts: the content side and the cost side.
Netflix, as the first mainstream service of its kind, has enjoyed a dominant position in the streaming market. It’s dedicating billions of dollars to maintaining this position, but doubt still creeps in regarding its ability to do so.
Competitors are revving up their spending on content. Now under AT&T's (NYSE:T) umbrella, HBO is aiming to go more mainstream, stepping away from the high-quality niche to compete with Netflix. It has already grabbed "Friends", one of the most popular shows on Netflix, for its own mainstream HBO Max service that will begin in 2020.
Walt Disney (NYSE:DIS) is expected to launch its streaming service, Disney+, in November, which will cost $7 (compared to Netflix’s $13), and will offer access to Disney-owned content such as the Marvel and Star Wars universes. Of course, Amazon (NASDAQ:AMZN) is worth a mention even though it is an older competitor and it also pays to know that Apple (NASDAQ:AAPL) has revealed that it will be soon launching its own Apple TV+ streaming service.
The costs of content creation are so high that it is likely that only a couple of companies will really be sustainably cash-flow positive in the next few years. Some of these services will inevitably fail and Netflix’s leverage means that should it fail, it will be a spectacular fail.
Another thing to note is that Netflix is a standalone company, while Disney, Amazon.com (NASDAQ:AMZN) and Apple have different revenue sources that can enable them to undercut Netflix and actively subsidize subscriptions to draw consumers. Netflix is limited by its lenders, and they have already taken a massive amount of debt.
Bottom Line
I do not regard Netflix as a safe investment. There are too many fundamental questions to which we don't yet hold the answer. I see Netflix as a fragile company from a financial point of view, given its leverage.
Unfortunately, there also seem to be quite a few clouds on the horizon, including less profitable international growth and increased competition. In the current growth and interest-rate environment, shorting a company without an immediate negative catalyst is not recommended. But on a longer time horizon, I expect Netflix’s stock price to better reflect the risks involved.